Recent years have featured unusually strong relative performance in small capitalization stocks. It is notable that in 2000, the 50 stocks in the S&P 500 with the largest market capitalizations carried a median price/earnings multiple of 35.6, while the stocks with the 50 smallest market capitalizations carried a median price/earnings multiple of just 10.1. This performance gap has not only been eliminated, but has now reversed. The median price/earnings multiple on the largest 50 stocks is now about 17.3, versus a multiple of 20.3 for the smallest 50 stocks.

As of June 30, 2006, the price/earnings ratio on the S&P 500 Index was 17.5. From the standpoint of recent years, this doesn’t appear to be an extreme level of valuation, yet if we examine other measures of valuation such as price/book, price/dividend, and price/revenue ratios, valuations are at levels rarely seen in history, except during the late 1990’s market bubble. Behind this apparent disagreement among valuation measures is a simple fact: earnings are unusually elevated here. Profit margins are at record levels, as are corporate profits as a share of GDP, while labor compensation and personal income as a share of GDP are equally depressed. There is a very strong tendency for elevated profit margins to be followed by tepid earnings growth for several years thereafter. Given that the unemployment rate is relatively low, and wage inflation is beginning to exceed productivity growth in recent reports, it would not be surprising to observe a decline in the share of GDP going to corporate profits and a rebound in the share going to labor compensation.

We can also observe the elevated level of earnings another way. Historically, S&P 500 earnings have been well contained by a 6% growth channel, with a top line connecting earnings peaks across economic cycles as far back as one cares to look. After a sharp plunge in earnings during the 2001-2002 recession, earnings have climbed back to that 6% growth line. The difficulty is that if we examine previous instances when S&P 500 earnings have been within 10-15% of that “top-of-channel” 6% growth line, the average price/earnings ratio of the S&P 500 Index has been less than 10. Unusually elevated earnings normally produce relatively low price/earnings ratios. In that context, the current multiple of 17.5 times top-of-channel earnings is actually extreme, and not at all in contradiction with other similarly extreme valuation measures.

The quality of internal market action (price/volume behavior, wide internal divergences, disparate industry action, hostile interest rate trends, and so forth) was also unfavorable on the measures we use. Rich valuations, rising interest rates, sluggish internals, and upward inflation pressures have rarely been favorable for stocks, and have frequently produced very negative outcomes. The overall return/risk profile associated with such conditions is clearly negative, on average.

In recent months, the financial markets have maintained a narrow focus on Federal Reserve policy, in hopes that an end to the recent tightening cycle will benefit the stock and bond markets. In my view, this focus is entirely misplaced... The Federal Reserve has the ability only to determine whether government liabilities held by the public take the form of money (currency and reserves) or Treasury bonds. The Fed’s open market operations are nothing but transactions to alter this mix. What the Federal Reserve cannot do, however, is to determine the total amount of government liabilities that must be absorbed by the public. This is the role of fiscal policy. The seemingly impressive record of monetary policy over the past two decades was not primarily due to a powerful or effective Federal Reserve, but was instead the result of fiscal discipline which brought the 5-year growth rate of the U.S. gross public debt from over 16% annually in 1987, to just 2% by 2002...

Inflation is the result of excessive growth in the quantity of government liabilities that must be absorbed by the public. It hardly matters what form these government liabilities take, because they are close portfolio substitutes. Excessive growth in government liabilities tends to cause a general devaluation in these liabilities (currency and Treasury securities) which is why inflation and interest rates tend to move in tandem...

During the 1990’s and in recent years, U.S. government budget deficits did not produce inflationary effects, precisely because foreign governments were willing to absorb as many government liabilities as the U.S. was able to issue... By accumulating what is now about half of the entire float of U.S. Treasury securities, foreign countries such as China and Japan have implicitly funded the entire U.S. budget deficit in recent years. This has allowed us to run large government budget deficits without financing them from our own domestic savings, so our savings have fortunately been entirely available for domestic investment... A slowing in foreign capital inflows will be enough to halt the growth of U.S. gross domestic investment here, including things like housing investment, factories, capital spending, and so forth. In my view, this is precisely what’s likely to happen over the coming years.

Any slowdown in foreign buying of U.S. Treasury securities will force those securities into the hands of U.S. investors instead... The result is likely to be persistent, structural inflation regardless of how the Fed conducts monetary policy.